OIL & GAS. Part Two. Scotland Means Business

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1 OIL & GAS Part Two Scotland Means Business

2 The Scotland Means Business reports have been prepared for N-56 by a study team that includes: This report, on the oil and gas sector has been prepared by BiGGAR Economics (the sections the implications for public finances) with input from Tulloch Energy (on Scottish oil and gas sector projections).

3 Contents Page 1! EXECUTIVE SUMMARY 1! 2! INTRODUCTION 3! 3! OBR PROJECTIONS FOR UK AND SCOTTISH PUBLIC FINANCES 6! 4! HISTORIC CONTRIBUTION TO TAX REVENUES 9! 5! OIL & GAS FORECASTS 13! 6! REVISED SCOTTISH PUBLIC SECTOR FINANCE PROJECTIONS 23! 7! POTENTIAL OIL FUND 27! 8! APPENDIX BASIS OF INDUSTRY-BASED SCENARIOS 30! Scotland Means Business: Oil & Gas Part Two The Impact on Public Finances

4 1 EXECUTIVE SUMMARY The policy focus for oil and gas should be on the development of the sector itself to ensure that its full potential is realised and its short and long term contribution to the Scottish economy is maximised. However, it is also true that the taxation revenues from the oil and gas sector have made a significant contribution to the public finances over the last four decades and can continue to do so in the future. If the recommendations of the Wood Review and those in the N-56 Scotland Means Business Oil and Gas Part One report are implemented, there is the opportunity to transform the Scottish public sector budget by significantly increasing oil taxation revenues collected over the next 30 years. This would mean that it is not too late for the UK Government or the Scottish Government to establish an oil fund. The Office of Budget Responsibility (OBR) has produced long term forecasts for the UK public finances, which also provide a basis for long term forecasts of Scottish public finances. They show the UK eliminating the deficit in , in line with UK Government policy, by which time UK debt will be around 1.5 trillion. Then they show the deficit returning in the 2020s. The OBR-based forecast for the Scottish economy is worse, with deficits of 4-5% for this decade and the 2020s. If the OBR forecasts proved correct, given the state of UK public finances, it would not be possible for the rest of the UK to fund this deficit in Scotland and so borrowing would be required or, perhaps more likely, a substantial cut to public spending in Scotland. The OBR s future projections are at odds with the historic position, with Scotland making a significant net contribution to UK finances, primarily as a result of significant oil taxation revenues in the 1980s. Analysis of the historic position shows that Scotland has not contributed to the build up of UK debt and would still have a cumulative surplus of in excess of 50 billion today, if Scottish public finances were treated separately from those of the UK as a whole. The OBR was set up in 2010 and so has not existed for long enough to assess its long term forecasting accuracy. However, its short term forecasts for the UK economy have been poor. For example, in 2010 the OBR forecast 2.8% GDP growth for the UK in 2012 but actual growth was 0.1%. The OBR-based projections that show the Scottish public finances in a worse position than those of the UK are because of the OBR oil and gas revenue projections, which have been repeatedly down-graded over the last two years and are out of line with industry and independent experts. The OBR oil and gas projections are based on much lower oil prices than the UK Government s projections and far less production than independent experts. For example, the OBR is forecasting production of less than 10 billion barrels of oil equivalent, a third less than the projections made by Professor Alex Kemp of the University of Aberdeen (who s model has been validated by industry). The OBR is also assuming that the costs of production ( 40 per barrel) will be much higher than the industry is projecting (around 30 per barrel). This is important since for any given level of production, higher costs mean lower profits, which, in turn, means lower tax revenues. The first N-56 Scotland Means Business Oil and Gas report set out policies that would see much higher production and higher tax revenues than those projected by the OBR, building on the recommendations of the Wood Review. Scotland Means Business: Oil & Gas Part Two The Impact on Public Finances 1

5 If these recommendations are implemented, oil taxation revenues will be far higher than projected by the OBR. Instead of the OBR s projected 57 billion, oil taxation revenues could be as high as 365 billion between 2014 and So instead of public sector deficits, Scotland s public finances could be comfortably in surplus, by as much as 7% of GDP at the end of this decade (more than 12 billion per annum), with surpluses of 9-11 billion per year in the 2020s and 5 billion per year in 2030s. Scotland s public finances would still be in surplus, even if a per capita share of UK public sector debt continued to be allocated to Scottish expenditure. This would provide an opportunity to build up an oil fund, as almost every other oil producing country has done, in order to ensure fiscal stability and to share the windfall with future generations. Even at the modest 3.2% real interest rate if all surpluses were invested in such a fund, it could grow to more than 300 billion (in today s prices) by the end of the 2030s under a high oil production scenario. This is more than double current annual economic output for Scotland. All of this is before any account is taken of policy changes that might be associated with independence or greater fiscal powers (such as those recommended in the N-56 Scotland Means Business: The Strategy report) that could improve economic performance and, therefore, Scottish public finances. Scotland Means Business: Oil & Gas Part Two The Impact on Public Finances 2

6 2 INTRODUCTION The policy focus for oil and gas should be on the development of the sector itself to ensure that its full potential is realised and its short and long term contribution to the Scottish economy is maximised. However, it is also true that the taxation revenues from the oil and gas sector have made a significant contribution to the public finances over the last four decades and can continue to do so in the future. This report is the second Scotland Means Business report on the oil and gas sector published by N-56 and focuses on the contribution that the sector has made to Scottish public finances and the contribution that it could make in the future. The first Scotland Means Business report on the oil and gas sector set out a range of macro and industrial policy measures required to maximise the economic contribution of the sector. This report sets out how implementing those policy measures could have a significant positive impact on Scottish public services over the next three decades. 2.1 Methodology The approach taken to projecting the impact of the oil and gas sector on Scottish public finances is summarised in Figure 2-1. The starting point for the analysis was the long-term projections that have been made by the Office for Budget Responsibility (OBR) for the UK public finances, the latest of which was published in July While the OBR report does not provide a separate projection for Scotland, the annual Government Expenditure and Revenue in Scotland (GERS) report 2 does provide data on the share of the UK s tax revenues and spending, covering the period to This provides a basis for a projection of Scottish public finances, based on OBR assumptions. This is an approach that has been used by others, notably the Institute for Fiscal Studies (IFS). However, the IFS report 3 was based on OBR s July 2013 projections, which were more pessimistic on public finances than the July 2014 report 4. The next element of the analysis was to use the historic public sector data published as part of GERS to determine the contribution that the oil and gas sector has made since This analysis shows that Scotland would have had a cumulative public sector surplus over the last 34 years and so has not contributed to increase in UK public sector debt over that period, particularly over the last seven years. On this basis, a revised projection of Scottish public sector finances has been prepared, removing the Scottish contribution to debt interest payments that has been included in the GERS publications. 1 Office for Budget Responsibility (July 2014), Fiscal Sustainability Report 2 Scottish Government (June 2014), Government Expenditure and Revenue in Scotland and associated publications and data, including Historic Fiscal Balances ( to ) 3 Institute for Fiscal Studies (November 2013), Fiscal Sustainability of an Independent Scotland 4 It should also be noted he IFS report also focuses mainly on the trajectory of public finances based on current policies (rather than policy change in the event of independence, as it s title suggests). Scotland Means Business: Oil & Gas Part Two The Impact on Public Finances 3

7 OBR has repeated downgraded its projections for future oil and gas revenues during the last two years. These projections are now considerably lower than forecasts being made by the oil and gas industry itself and by respected independent analysts such as Professor Alex Kemp of the University of Aberdeen. This analysis shows the impact that a number of oil and gas industry projections for prices, production and costs and, therefore, oil and gas taxation revenues would have on Scottish public finances. The final step in the analysis was to combine the analysis of Scottish public finances, excluding debt interest payments, with oil and gas industry projections. On this basis it has also been possible to consider the prospects for an oil and gas fund, as in in place in most other oil producing countries. Figure 2-1: Summary of Methodology & Sources for Public Finance Projections OBR$$ Projec+ons$$ for$uk$public$$ finances$ GERS$data$on$$ Sco=sh$share$$ of$uk$tax$$ &$spend$ O&G$ Projec+ons$ from$o&g$ Industry$ OBRDbased$ Projec+ons$$ for$sco=sh$ public$finances$ GERS$data$on$ Historic$ Fiscal$$ Balances$$$ O&GDadjusted$ Projec+ons$$ for$sco=sh$ public$finances$ DebtDadjusted$ Projec+ons$$ for$sco=sh$ public$finances$ Adjusted$ Projec+ons$$ for$sco=sh$ public$finances$ 2.2 Report Structure This report is structured as follows: Section 3 summarises OBR projections for UK public finances and OBRbased projections for Scottish public finances; Section 4 considers the historic contribution that the oil and gas sector has made to Scottish public finances and includes projections of Scottish public finances, taking account of that historic contribution; Section 5 reviews OBR projections for the oil and gas sector and oil and gas revenues and compares them to industry and independent expert projections; Scotland Means Business: Oil & Gas Part Two The Impact on Public Finances 4

8 Section 6 presents projections of Scottish public finances based on industry oil and gas revenue projections; and Section 7 considers the prospects for establishing an oil fund. Scotland Means Business: Oil & Gas Part Two The Impact on Public Finances 5

9 3 OBR PROJECTIONS FOR UK AND SCOTTISH PUBLIC FINANCES The OBR was set up by the UK Government in 2010 to provide independent and authoritative analysis of the UK public finances. It produces two sets of forecasts for UK public services. The Economic and Fiscal Outlook is published twice a year, at the time of each UK Budget and Autumn Statement, and contains fiveyear forecasts for the economy and the public finances. In July of each year, long-term forecasts are published in the Fiscal Sustainability Report. The OBR has not been in existence long enough to assess its performance in making long-term forecasts. However, its short-term forecasts have often proved to be wide of the mark. For example, its June 2010 forecasts 5 for GDP growth were: for 2010: 1.2% (actual growth was 1.7% so the forecast error for 2010 was 42%, despite being made almost half way through the year); for 2011: 2.3% (actual growth was 1.1% so the forecast error was 52%); and for 2012: 2.8% (actual growth was 0.1% so the forecast error was 96%). To be fair to the OBR, the difficulties of economic forecasting are well known. As the economist J.K. Galbraith put it, The only function of economic forecasting is to make astrology look respectable. The OBR recognises the inherent difficulties in forecasting, in one of its own reports that reviews its forecasting performance 6 : Forecasts provide an essential basis for setting policy into the future. But since the future can never be known with precision, forecasts are surrounded by significant uncertainty and will inevitably prove to be wrong in at least some respects. With forecasts errors of such a proportion in short-term forecasts, it seems sensible to treat long-term forecasts with even more caution. However, the longterm forecasts do have some value since they provide some basis for estimating the effect that changes in some of the key underlying assumptions can make to the health of the public finances. This section summarises the OBR long-term forecasts for the UK public finances and derives long-term forecasts for the Scottish economy, based on the OBR UK forecasts. The OBR s oil and gas forecasts are discussed later in this report and compared with forecasts from industry and from independent experts. 3.1 OBR Projections for UK Economy The OBR projections for the UK economy 7 start with a budget deficit of 5.8% of GDP. This means that the taxes collected by the UK Government in were not sufficient to pay for public spending commitments, with the gap between the two equivalent to 5.8% of the total economy. So the UK Government was required to borrow to fund that gap, further increasing the UK s total public sector 5 Office for Budget Responsibility (June 2010), Economic and Fiscal Outlook 6 Office for Budget Responsibility (October 2013), Forecast Evaluation Report 7 Office for Budget Responsibility (July 2014), Fiscal Sustainability Report Scotland Means Business: Oil & Gas Part Two The Impact on Public Finances 6

10 debt, to almost 1.3 trillion by the end (March 2014), equivalent to around 22,000 for every person in the UK. The OBR is forecasting that the deficit will be eliminated over a five-year period (Figure 3-1), which is in line with the current UK Government s stated aim. Over the next five years, this continued deficit will mean that the UK s cumulative public sector debt position will continue to increase, to around 1.5 trillion by The OBR then shows a broadly balanced budget until and then a deteriorating position with the deficit increasing over time to reach 1.9% of GDP in So the OBR s central forecast is that, far from paying down debt, the UK s accumulated debt is forecast to continue to increase over the next three decades. Figure 3-1: OBR Projections for UK Public Finances (Net Fiscal Balance as % GDP) Public'Secfor'Surplus/Deficit'as'%'GDP' 2.0%& 0.0%&!2.0%&!4.0%&!6.0%& 2013!14& 2014!15& 2015!16& 2016!17& 2017!18& 2018!19& 2019!20& 2020!21& 2021!22& 2022!23& 2023!24& 2024!25& 2025!26& 2026!27& 2027!28& 2028!29& 2029!30& 2030!31& 2031!32& 2032!33& 2033!34& 2034!35& 2035!36& 2036!37& 2037!38& 2038!39& 2039!40& 2040!41& UK&(OBR)&!8.0%& Source: OBR Fiscal Sustainability Report, July Scotland s % of UK Tax Revenues and Public Spending The OBR does not publish a separate long-term forecast of Scottish public finances. However, it is possible to derive a forecast from OBR assumptions about UK public finances, using the data published in the Government Expenditure and Revenue in Scotland (GERS) report. The latest GERS report, published in March 2014, which covered the fiscal year, showed that Scotland, with 8.4% of the population, received 9.3% of the UK s public spending (including the spending of the UK Government in and on behalf of Scotland, as well as Scottish Government and local government spending) and accounted for 9.2% of tax revenues. However, can be reasonably described as an unusual year. Data on Scotland s fiscal balances is available going back to On average, Scotland s share of UK tax revenues collected has been 10.5% while Scotland s share of spending has been less, 9.6%. Scotland Means Business: Oil & Gas Part Two The Impact on Public Finances 7

11 Scotland s share of UK onshore tax revenues and UK spending are consistent over time, at around 8.3% and 8.4% respectively. Offshore tax revenues vary in absolute terms but Scotland s share of UK offshore tax revenues is around 90% on average. Table 3-1 Scotland s Share of UK Tax Revenues and Public Spending Scotland as % UK Average Offshore taxes 91.1% 91.4% 90.5% 94.0% 84.2% 90.2% Onshore taxes 8.3% 8.3% 8.3% 8.2% 8.2% 8.3% Public spending 9.4% 9.2% 9.2% 9.3% 9.3% 9.3% Source: GERS These figures provide a basis for a projection of Scottish public finances, based on the OBR assumptions. 3.3 OBR-based Projections for Scottish Public Finances Based on OBR projections, Scottish public finances would be in a worse position than the UK as a whole. This is because the OBR is forecasting a substantial decline in revenues from oil and gas, discussed in some detail later in this report. It should also be noted that this is based on current policies, with no account taken of policy changes that might be associated with independence or further fiscal devolution. The OBR-based projection for Scotland would see a net fiscal deficit of 7.4% in , reducing to 2.3% in and then increasing again, to reach more than 5% by (Figure 3-2). Given that the UK public finances are projected to be in deficit in this period, it would not be possible for the rest of the UK to fund this deficit in Scotland and so borrowing would be required to fund such a deficit or, perhaps more likely, a substantial cut to public spending in Scotland. Figure 3-2: OBR-Based Projections for UK and Scottish Public Finances (Net Fiscal Balance as % GDP) Public'Secfor'Surplus/Deficit'as'%'GDP' 2.0%& 1.0%& 0.0%&!1.0%&!2.0%&!3.0%&!4.0%&!5.0%&!6.0%&!7.0%& 2013!14& 2014!15& 2015!16& 2016!17& 2017!18& 2018!19& 2019!20& 2020!21& 2021!22& 2022!23& 2023!24& 2024!25& 2025!26& 2026!27& 2027!28& 2028!29& 2029!30& 2030!31& 2031!32& 2032!33& 2033!34& 2034!35& 2035!36& 2036!37& 2037!38& 2038!39& 2039!40& 2040!41& UK&(OBR)& Scotland&(OBR)&!8.0%& Source: OBR Fiscal Sustainability Report July 2014 & GERS Historic Fiscal Balances Scotland Means Business: Oil & Gas Part Two The Impact on Public Finances 8

12 4 HISTORIC CONTRIBUTION TO TAX REVENUES 4.1 Scottish Historic Fiscal Balances Scotland Means Business: The Facts included an analysis of Scotland s public finances and their contribution to UK public finances. This showed that, while the balance varies from year to year, on average, Scotland has accounted for 9.5% of tax revenues and 9.4% of government spending since devolution in 1999, and so Scotland more or less pays its way within the UK public finances. However, since , Scotland, with 8.3% of the UK s population, has received 9.6% of UK government spending and has been the source of 10.5% of UK taxation revenues. This net contribution to the UK public finances from Scotland is as a result of Scotland s geographic share of oil revenues. Between and total taxes collected from the Scottish economy totalled 1,049 billion. Of this total 886 billion was collected from the onshore economy and 163 billion from the offshore economy 8, 15.5% of the total. As Figure 4-1 shows, in the mid 1980s, offshore taxation accounted for as much of 50% of taxation collected from Scotland. More recently it has been in the 10-20% range. Figure 4-1: Onshore and Offshore Tax Receipts (Scottish Geographic Share) Onshore"Tax"Revenues" Offshore"Tax"Revenues" 60,000" 50,000" 40,000" m& 30,000" 20,000" 10,000" 0" 1980/81& 1981/82& 1982/83& 1983/84& 1984/85& 1985/86& 1986/87& 1987/88& 1988/89& 1989/90& 1990/91& 1991/92& 1992/93& 1993/04& 1994/95& 1995/06& 1996/97& 1997/98& 1998/99& 1999/00& 2000/01& 2001/02& 2002/03& 2003/04& 2004/05& 2005/06& 2006/07& 2007/08& 2008/09& 2009/10& 2010/11& 2011/12& 2012/13& Source: GERS , Scottish National Accounts Project (Historic Fiscal Balances) When offshore taxation revenues are included, it can be seen that Scotland s public finances have typically been healthier than UK public finances as a whole (Figure 4-2). In the 1980s, Scotland had a substantial public sector surplus, as 8 The taxation identified as offshore taxation in official statistics covers only corporation tax associated with UKCS oil production and other production related taxes. So other taxes such as employment taxes and those associated with the oil and gas supply chain and not included and so the available data understates the historic contribution that the oil and gas sector has made to UK taxation revenues. Scotland Means Business: Oil & Gas Part Two The Impact on Public Finances 9

13 high as 15% of GDP, at a time of decline in the onshore industrial economy, with many closures of tradition industries. In , the deficit between spending and tax in Scotland (net fiscal balance) was equivalent to 5.0% of GDP (Gross Domestic Product, a measure of the size of the economy). The comparable figure for the UK as a whole was 7.9% of GDP. In the Scottish net fiscal balance increased to 7.3%, compared with 6.3% for the UK. Figure 4-2: UK and Scottish Net Fiscal Balances 18.0%' 13.0%' 8.0%' 3.0%'!2.0%'!7.0%'!12.0%' Public'Sector'Net'Balance'as'%'of'GDP' Scotland' 1980/81' 1981/82' 1982/83' 1983/84' 1984/85' 1985/86' 1986/87' 1987/88' 1988/89' 1989/90' 1990/91' 1991/92' 1992/93' 1993/94' 1994/95' 1995/96' 1996/97' 1997/98' 1998/99' 1999/00' 2000/01' 2001/02' 2002/03' 2003/04' 2004/05' 2005/06' 2006/07' 2007/08' 2008/09' 2009/10' 2010/11' 2011/12' 2012/13' Source: GERS , Scottish National Accounts Project (Historic Fiscal Balances) However, the above figures do not fully reflect the contribution that Scotland has made to the UK public finances as a result of oil revenues. The level of UK government debt has increased from billion in to 1,258 billion ( 1.26 trillion) in March 2014 ( 20,000 per person) and is forecast to increase to more than 1.55 trillion by The OBR puts UK debt interest payments at 47.6 billion per annum in and forecasts this to rise to 75.2 billion in Scotland s per capita share of that would more than 6 billion, equivalent to 10% of current public spending. The Scottish net fiscal balances that are shown in Figure 4-2 (and the blue line on Figure 4-3) include a Scottish per capita contribution to meeting public sector debt interest payments. While this might be a reasonable statistical assumption to make, it does not reflect the true fiscal position of Scotland. If public sector debt interest payments are excluded (other than those that relate to the debt), Scotland's net fiscal deficit in reduces to 21 billion, just 15% of GDP (the red line on Figure 4-3). Even this understates the relative health of Scottish public finances. Had the substantial fiscal surpluses in the 1980s been invested in a stabilisation fund (a sovereign wealth fund), interest could have been earned (Norway s sovereign UK' 9 Office of Budget Responsibility forecasts, March 2014 Scotland Means Business: Oil & Gas Part Two The Impact on Public Finances 10

14 wealth fund has achieved an average real rate of return of 4.3% per annum 10 ) and a substantial fund built up as a hedge against tough economic conditions, such as those being faced currently. The green red line on Figure 4-3 shows what Scotland s net government debt would have been had separate public sector accounts been maintained. This includes interest on net surpluses of 4.3% per annum (an under-estimate since nominal interest rates are likely to have been higher), with an accumulated net surplus of 52 billion in , equivalent to 36% of GDP, almost 10,000 per person. Figure 4-3: Scottish Public Finances Cumulative Surplus Scotland's#Cumula0ve#Public#Sector#Surplus#(Deficit)#since#1980# GERS##Surplus#(Deficit)# Excluding#Debt#Interest#Share# m# 75,000& 65,000& 55,000& 45,000& 35,000& 25,000& 15,000& 5,000&!5,000&!15,000&!25,000&!35,000&!45,000&!55,000&!65,000& 1980/81& 1981/82& 1982/83& 1983/84& 1984/85& 1985/86& 1986/87& 1987/88& 1988/89& 1989/90& 1990/91& 1991/92& 1992/93& Source: Calculations based on GERS , Scottish National Accounts Project (Historic Fiscal Balances) Analysis of the same data by other economists has also projected an overall surplus for this period; for example, the Scottish Economy Watch blog by Professor Brian Ashcroft has put the overall surplus at 68 billion Debt Adjusted Scottish Public Sector Finance Projections 1993/04& 1994/95& Given that Scotland has not contributed to the build up of UK debt, it is reasonable not to include a share of debt interest payments in projections for Scottish public sector finances. As Figure 4-4 shows, without a share of debt interest payments allocated to Scottish expenditure, Scottish public sector finances would be in a stronger position than the UK as a whole over the next few years (even with the OBR s very pessimistic oil revenue projections), with the deficit eliminated a year earlier in Scotland than for the UK and a public sector surplus of more than 1% of GDP in /06& 1996/97& 1997/98& 1998/99& 1999/00& 2000/01& 2001/02& 2002/03& 2003/04& 2004/05& 2005/06& 2006/07& 2007/08& 2008/09& 2009/10& 2010/11& 2011/12& 2012/13& 10 IMF Survey Magazine (9 July 2008), Norway's Oil Fund Shows the Way for Wealth Funds 11 Professor Brian Ashcroft (10 July 2013), Has Scotland already spent its oil fund? Scottish Economy Watch Blog Scotland Means Business: Oil & Gas Part Two The Impact on Public Finances 11

15 As a result of assumptions on declining oil revenues, a deficit would return in the mid 2020s, increasing to more than 3% of GDP in the late 2030s. Figure 4-4: Debt-Adjusted Projection for Scottish Public Finances (Net Fiscal Balance as % GDP) Public'Secfor'Surplus/Deficit'as'%'GDP' 2.0%& 1.0%& 0.0%&!1.0%&!2.0%&!3.0%&!4.0%&!5.0%&!6.0%&!7.0%& 2013!14& 2014!15& 2015!16& 2016!17& 2017!18& 2018!19& 2019!20& 2020!21& 2021!22& 2022!23& 2023!24& 2024!25& 2025!26& 2026!27& 2027!28& 2028!29& 2029!30& 2030!31& 2031!32& 2032!33& 2033!34& 2034!35& 2035!36& 2036!37& 2037!38& 2038!39& 2039!40& 2040!41& UK&(OBR)& Scotland&(OBR)& Scotland&(OBR,&No&Debt)&!8.0%& Source: OBR Fiscal Sustainability Report July 2014 & GERS Historic Fiscal Balances Scotland Means Business: Oil & Gas Part Two The Impact on Public Finances 12

16 5 OIL & GAS FORECASTS 5.1 OBR and HM Treasury Forecasting Track Record The OBR forecasts that show Scottish public finances in a weaker position than the UK, in contrast to the historic stronger performance, are primarily due to pessimistic assumptions made on oil revenues. However, the track record of OBR and HM Treasury on forecasting future oil revenues is poor. The OBR was formed in 2010 and prior to that HM Treasury produced forecasts for oil revenues. The OBR and HM Treasury s previous predictions on oil and gas revenue have generally been inaccurate with large errors, as can be seen from the historic forecasts still available on the OBR website. For example, the June 2010 OBR forecast for oil and gas industry expenditure (from which estimates of tax revenues are made) for was 15.1 billion and the actual was 22.1 billion, almost 50% higher than forecast. HM Treasury s five-year oil and gas revenue forecasts (that is the forecasts made five-years ahead) have been particularly unreliable, with a mean percentage error of 39.4% (Figure 5-1). The five-year forecasts made for the years from to were significant underestimates, with a negative mean percentage error of 50.1%. For years to the five-year forecasts were significant overestimates, with a positive mean percentage error of 25.4%. The only year, where a forecast was within 10% of the actual outturn of oil & gas, was Figure 5-1: Oil & Gas Revenue Forecasts 5 Years in Future v Actual Oil$&$Gas$Revenue$Forecasts$5$Years$in$Future$v$Actual$$ 58Year$Forecast$ Actual$Ou9urn$ 12" 10" 8" bn$ 6" 4" 2" 0" 2006(07" 2007(08" 2008(09" 2009(10" 2010(11" 2011(12" 2012(13" Source: OBR The forecasts have also been inconsistent, with regular large revisions to projected oil revenues. For example, Figure 5-2 shows the actual oil revenues for (the red line) and the wide range of HM Treasury forecasts made over the previous five years. Figure 5-3 shows the forecasts for made by HM Treasury and the OBR against actual outturn. Scotland Means Business: Oil & Gas Part Two The Impact on Public Finances 13

17 Figure 5-2: Variation in Oil & Gas Revenue Forecasts for & Actual Varia%on(in(Forecasts(for( (&(Actual( Forecasts( Actual(Ou9urn( 12" 10" 8" 6" 4" 2" 0" 2004" 2005" 2006" 2007" 2008" 2009" Source: OBR Figure 5-3: Variation in Oil & Gas Revenue Forecasts for & Actual Varia)on$in$Forecasts$for$ $&$Actual$ Forecasts$ Actual$Ou;urn$ 12" 10" 8" bn$ 6" 4" 2" 0" 2008" 2009" 2010" 2010"Summer" 2011"March" 2012" 2013"March" Source: OBR 5.2 Basis of Oil Revenue Forecasts Given the large oil revenue forecast errors of the OBR and HM Treasury, even over the short-term, it does not seem sensible to rely on their longer-term oil revenue forecasts. It is worth considering what assumptions are required to make such projections and so the sources of the forecasting errors made by the OBR and HM Treasury. Scotland Means Business: Oil & Gas Part Two The Impact on Public Finances 14

18 Forecasting future oil revenues requires assumptions to be made about a number of inter-related factors, including: reserves, that is, the proven and anticipated oil reserves that have not yet been tapped; future oil price expectations, which will influences made on investment in exploration and development; actual oil prices, which determine gross revenues associated with oil produced; production, that is, the volume of oil produced; the costs of exploration and production, and so, the profits associated with oil produced (and from which taxes are paid); and the taxation regime. The OBR is out of line with industry and expert opinion on prices, production and costs. 5.3 Oil Price Forecasts The OBR projections for oil prices are based on a decline in oil prices over the next few years, to just less than $100 per barrel and then a gradual increase from 2020 to $160 by The OBR is forecasting that the oil price over the next five years is well below where it has been over the last five years. Oil prices can be volatile and can change rapidly in response to world events, such as war in the Middle East. However, the long term underlying trend is for oil prices to rise over time, as Figure 5-4 shows. Figure 5-4: Historic Oil Prices Brent&Monthly&Spot&Price&($/Barrel)& Linear&(Brent&Monthly&Spot&Price&($/Barrel))& 120" 100" $" 80" 60" 40" 20" 0" May+1987" Feb+1988" Nov+1988" Aug+1989" May+1990" Feb+1991" Nov+1991" Aug+1992" May+1993" Feb+1994" Nov+1994" Aug+1995" May+1996" Feb+1997" Nov+1997" Aug+1998" May+1999" Feb+2000" Nov+2000" Aug+2001" May+2002" Feb+2003" Nov+2003" Aug+2004" May+2005" Feb+2006" Nov+2006" Aug+2007" May+2008" Feb+2009" Nov+2009" Aug+2010" May+2011" Feb+2012" Nov+2012" Aug+2013" May+2014" Source: US Energy Information Administration Scotland Means Business: Oil & Gas Part Two The Impact on Public Finances 15

19 Given these historic trends, and the established global trend that has seen demand for energy increase, it is not surprising that many expect prices to continue to rise. As Figure 5-5 shows, if the historic trend continues, oil prices would reach $150 in the 2020s and $200 around Figure 5-5: Trend Projection Based on Historic Oil Prices 200" 180" 160" 140" 120" $" 100" 80" 60" 40" 20" Brent&Monthly&Spot&Price&($/Barrel)& Linear&(Brent&Monthly&Spot&Price&($/Barrel))& 0" May+1987" Feb+1989" Nov+1990" Aug+1992" May+1994" Feb+1996" Nov+1997" Source: US Energy Information Administration Aug+1999" May+2001" Feb+2003" Nov+2004" Aug+2006" May+2008" Feb+2010" Nov+2011" The UK Government s Department of Energy and Climate Change s (DECC) central projection is for oil prices to rise to $120 per barrel by 2020 (and further to $135 by 2030) 12. DECC s high projection would see oil prices of $150 by 2020 (and $195 by 2030). Recent projections by the OECD 13 are for oil prices to reach $190 by On this basis, the OBR assumptions seem very conservative. The analysis presented later in this report therefore considers the potential impact of alternative price scenarios, one close to the OBR assumption, higher prices and lower prices (Figure 5-6). The higher price scenario is broadly consistent with the historic trend in prices but is lower than some projections that have been made, such as that by the OECD. Aug+2013" May+2015" Feb+2017" Nov+2018" Aug+2020" May+2022" Feb+2024" Nov+2025" Aug+2027" May+2029" Feb+2031" Nov+2032" Aug+2034" May+2036" Feb+2038" Nov+2039" 12 Department of Energy and Climate Change (July 2013), DECC Fossil Fuel Price Projections 13 Jean-Marc Fournier, Isabell Koske, Isabelle Wanner, Vera Zipperer (8 March 2013), OECD Economics Department Working Paper 1031, The Price of Oil Will it Start Rising Again? Scotland Means Business: Oil & Gas Part Two The Impact on Public Finances 16

20 Figure 5-6: Oil Prices Used in Analysis 200" 150" $" 100" 50" 5.4 Production Forecasts Reserves 0" 2014'15" 2015'16" 2016'17" 2017'18" 2018'19" 2019'20" 2020'21" 2021'22" 2022'23" 2023'24" 2024'25" 2025'26" 2026'27" 2027'28" 2028'29" 2029'30" 2030'31" 2031'32" 2032'33" 2033'34" 2034'35" 2035'36" 2036'37" 2037'38" 2038'39" 2039'40" 2040'41" OBR"(Central)" Low"(Industry)" Medium"(Industry)" High"(Industry)" New reserves are discovered each year so total production is now expected to be around twice as much as had been predicted in the mid-1970s. In 1975 there were estimated to be 26 billion barrels of oil equivalent (bn boe) but 42 bn boe had already been produced by The UK s remaining commercially recoverable offshore oil and gas reserves are widely accepted to stand at somewhere between 15 and 24 bn boe 14. In July 2014 DECC reduced its estimate to between 11 and 21 bn boe, apparently to reflect recent low levels of exploration. However, some experts believe that the upper bound could be higher. For example, at the SCDI s Oil & Gas and Scotland s Future conference in February 2012 Malcolm Webb, Chief Executive of Oil & Gas UK, asserted I personally suspect it will eventually be shown to be much greater than the 24 billion barrels we currently estimate 15. This would be consistent with the historic position where production has exceeded the reserves that had been projected. There is also widespread acceptance that the vast majority of these reserves lie in Scottish waters. In its April 2013 report the House of Lords Select Committee on Economic Affairs stated Most witnesses agreed that Scotland would gain approximately 90% of the oil and gas reserves Oil & Gas UK Economic Report Oil & gas and Scotland s future conference report, SCDI, The economic implications for the United Kingdom of Scottish Independence, House of Lords Select Committee on Economic Affairs, Apr 2013 Scotland Means Business: Oil & Gas Part Two The Impact on Public Finances 17

21 5.4.2 University of Aberdeen Production Projections The oil economist Professor Alex Kemp of the University of Aberdeen has undertaken work on scenarios for future production, using a UKCS model which employs Monte Carlo risk analysis to a large database of field level data built up over many years and validated by industry. At an oil price of $90 17, production to 2050 (from 2014) is estimated at 15 bn boe (Figure 5-7). At higher oil prices, higher levels of production would be expected, since greater investment in exploration would be expected and higher cost fields would become viable. Figure 5-7: University of Aberdeen Production Projections Source: Kemp & Stephen, University of Aberdeen 18 In his evidence to the Scottish Parliament in April Professor Kemp presented data that show that, in the period to , 14 bn boe could be produced in a conservative $90 oil price scenario if following the implementation of the Wood Review proposals, the production efficiency problem is largely resolved by If the production efficiency problem is only partially resolved, production is estimated to be 13.1 billion boe over the same period OBR Production Forecasts The OBR s 2014 central projections appear to assume that the Wood Review has no positive impact on production across the basin. The Wood Review states that the urgent and full implementation of the recommendations in this report will have the potential to deliver, at the low end, an additional 3-4 billion boe over the next 20 years, worth approximately 200 billion to the UK s economy at today s prices, 17 Note that this is not a prediction of future oil prices but the price used by oil company economists for investment appraisals. 18 Professor Alexander G. Kemp and Linda Stephen (April 2014), Scottish Independence and the North Sea Oil and Gas Sector, University of Aberdeen 19 Scotland Means Business: Oil & Gas Part Two The Impact on Public Finances 18

22 and at the high end will put the UK in a much stronger position to get closer to the 24 billion boe potential. 20 OBR s estimates of production for the period to 2041 are 8.1 billion boe (low), 9.5 billion boe (central, Figure 5-8) and 11.3 billion boe (high). At their heart, the OBR s long term production profiles are based on the assumption that production declines by 5% per annum, rather than any analysis of the potential of the UKCS or commercial decisions made on individual fields. Figure 5-8: OBR Production Forecast (Central) 0.6" 0.5" 0.4" Bn%BoE%% 0.3" per%year% 0.2" 0.1" 0" 2014% 2015% Source: OBR Industry Based Production Projections The value of the remaining resource depends on numerous factors, prime amongst which are market prices, production volumes, the fiscal regime and costs. While nothing can be done to influence market prices; volume produced, the fiscal regime and the basin s cost base will all be influenced by how well industry and the Government respond to the challenges summarised in the Wood Review. Three production scenarios (Low, Medium and High) and three price scenarios (Low, Medium and High, based on the UK Government s future oil price assumptions, published by DECC) were analysed for this study. Further details on the assumptions and sources used for these projections are provided in the appendix. The results of the nine scenario combinations are presented in Figure 5-9. In terms of the volume of production, over the period 2014 to 2040, the three scenarios would see: low production scenarios: 9.5 bn boe; medium production scenarios: 12.2 bn boe; and high production scenarios: 14.9 bn boe. 2016% 2017% 2018% 2019% 2020% 2021% 2022% 2023% 2024% 2025% 2026% 2027% 2028% 2029% 2030% 2031% 2032% 2033% 2034% 2035% 2036% 2037% 2038% 2039% 2040% 20 UKCS maximising recovery review: final report, Sir Ian Wood, Feb 2014 Scotland Means Business: Oil & Gas Part Two The Impact on Public Finances 19

23 Figure 5-9: Summary Industry Based Scenarios, Average Values per Annum Billion3/3year3(2014) Historic Low Prod. Low3 Low Prod. Med.3 Low Prod. High3 Med. Prod. Low3 Med. Prod. Med.3 Med. Prod. High3 High Prod. Low3 High Prod. Med.3 High Prod. High3 Opex Capex3+3E&A Decomm. Tax Operators From the perspective of Scottish business, the key point is that even in the Low Production/Low Price scenario expenditure will be vast with an average annual spend of 98% of the average level witnessed over the last 43 years. This expenditure has enabled the development of a vibrant Scottish oil and gas sector that today supports more than 200,000 Scottish jobs and has provided the foundation upon which Scottish based companies have sales in overseas subsidiaries and exports valued at 10 billion, accounting for half of total sales. It is crucial that Scotland seizes the opportunity that its indigenous oil and gas sector will present over the next three decades and beyond to grow businesses that are anchored in Scotland and operate globally. Decommissioning is often portrayed as an almost unbearable burden. The scenarios above show that decommissioning costs are a small percentage of the overall value left on the UKCS, and are able to be borne and still leave significant taxation revenue for government and post-tax profits for operators Summary of Production Projections The projections from OBR, the University of Aberdeen projections and those based on industry expectations are summarised in Figure 5-10, showing production over the period 2014 to 2040 of: OBR Central: 9.8 bn boe; OBR High: 11.6 bn boe; OBR Low: 8.3 bn boe; University of Aberdeen (assuming Wood Review implemented and production efficiency problem largely resolved by 2019): 14.0 bn boe; Industry-based (High): 14.9 bn boe; Industry-based (Medium): 12.2 bn boe; and Scotland Means Business: Oil & Gas Part Two The Impact on Public Finances 20

24 Industry-based (Low): 9.5 bn boe. Figure 5-10: Production Forecasts Produc,on# #!16.0!!!14.0!!!12.0!!!10.0!! Bn#boe#!8.0!!!6.0!!!4.0!!!2.0!!!"!!!! OBR!Central! OBR!High! OBR!Low! University!of! Aberdeen! Industry!H! Industry!M! Industry!L! Source: OBR, Kemp & Stephen of University of Aberdeen 5.5 Cost Projections Debate around the OBR oil projections has focused on the production and price assumptions that have been adopted. However, the assumptions made on the costs of production also have a significant impact on future tax revenues since higher costs means lower profits from which tax revenues can be collected. This effect is amplified when the OBR s high cost assumptions are combined with its low price assumptions. There is no question that future costs of production will increase when compared with historic costs and this is what would be expected in a mature basin. However, the OBR projections on costs are very high. The OBR assumes that unit operational and capital costs continue to trend upward at an alarming rate, again appearing to assume that the Wood Review and existing industry initiatives have little or no impact on controlling costs and making the UKCS a more attractive basin in which to invest. The OBR consistently predicts operational and capital expenditure around 4-5 billion per annum higher than Professor Kemp s comparable figures. For the industry based scenarios capital and operational costs for the period are taken from Oil & Gas UK s 2014 Economic Report, with values beyond this assumed to increase in line with oil prices as per the OBR s methodology as a conservative fiscal assumption. Exploration expenditure was assumed to increase to 2 billion per annum in 2018 as per the OBR s hypothesis and decrease in line with production thereafter. The total costs of production for each of the scenarios is summarised in Figure 5-11 while the average costs per barrel produced for each is summarised in Figure Scotland Means Business: Oil & Gas Part Two The Impact on Public Finances 21

25 Figure 5-11: Cost of Production Scenarios!500!! Capex!2014"40!( bn)! Opex!2014"40!( bn)!!450!!!400!!!350!!!300!! bn$!250!!!200!!!150!!!100!!!50!!!"!!!! OBR!(Central)! OBR!High! OBR!Low! University!of! Aberdeen! Industry!H! Industry!M! Industry!L! Figure 5-12: Cost of Production Scenarios (Average Cost per Barrel)!40!! Capex!per!barrel!2014"40!( )! Opex!per!barrel!2014"40!( )!!35!!!30!!!25!! "!20!!!15!!!10!!!5!!!"!!!! OBR!(Central)! OBR!High! OBR!Low! University!of! Aberdeen! Industry!H! Industry!M! Industry!L! The effects of the scenarios for oil prices, production volumes and costs on future oil revenues and how this impacts on public finances are highlighted in the next section. Scotland Means Business: Oil & Gas Part Two The Impact on Public Finances 22

26 6 REVISED SCOTTISH PUBLIC SECTOR FINANCE PROJECTIONS 6.1 Oil and Gas Revenue Projections The effects of the different scenarios for oil prices, production volumes and costs on future oil taxation revenues are summarised in Figure 6-1. So when the OBR forecasts on oil prices, production volumes and the costs of production are combined, the effect on taxation revenues is dramatic when compared with industry based projections. The total projected tax revenues for each of the scenarios for (in 2014 prices) are: OBR Central: 57 billion; OBR High Price: 83 billion; OBR Low Production: 44 billion; Industry-based (High Price/ High Production): 365 billion; Industry-based (Medium Price/ Medium Production): 149 billion; and Industry-based (Low Price/ Low Production): 14 billion. As was noted in the previous section, even the low price and low production scenario would provide significant opportunities for Scottish companies. However, it would generate far lower taxation revenues than have been the case historically. It is therefore in the interests of the Government, and of consumers of public services, that the Wood Review recommendations are implemented and that the recommendations of the previous N-56 Oil and Gas report are given full consideration, so that a higher production scenario can be realised. Figure 6-1: Comparison of OBR and Industry Oil & Gas Tax Revenue Forecasts Tax!Revenues!from!O&G!( bn)!!16.0!!!14.0!!!12.0!!!10.0!!!8.0!!!6.0!!!4.0!!!2.0!!!"!!!! OBR$Central$ OBR$Low$Produc7on$ Industry;based$(Medium/Medium)$ OBR$High$Price$ Industry;based$(High/High)$ Industry;based$(Low/Low)$ 2014"15! 2015"16! 2016"17! 2017"18! 2018"19! 2019"20! 2020"21! 2021"22! 2022"23! 2023"24! 2024"25! 2025"26! 2026"27! 2027"28! 2028"29! 2029"30! 2030"31! 2031"32! 2032"33! 2033"34! 2034"35! 2035"36! 2036"37! 2037"38! 2038"39! 2039"40! 2040"41! Scotland Means Business: Oil & Gas Part Two The Impact on Public Finances 23

27 When the industry-based projections for oil taxation revenues are used for projection of Scottish public finances over the next three decades, with the potential for future oil revenues to exceed the total oil revenues to date, provided the appropriate policy mix is implemented. 6.2 Public Finance Projections Including Debt Interest Even including a Scottish per capita share of debt interest payments, higher oil taxation revenues could make a significant difference to Scottish public finances (Figure 6-2). Under the medium scenario, the deficit would be eliminated by , as OBR projects for the UK as a whole, although the deficit would then return and grow in the 2020s and 2030s, in the absence of fiscal policy action to change this trajectory. However, under the high scenario, Scotland would have a balanced budget in and significant public sector surpluses from , at around 4% of GDP, an annual surplus of more than 6 billion. Figure 6-2: Public Finance Projections with Industry-based Oil Revenues (Including Debt) Public'Sector'Surplus/Deficit'as'%'GDP' 10.0%& 8.0%& 6.0%& 4.0%& 2.0%& 0.0%&!2.0%&!4.0%&!6.0%&!8.0%&!10.0%& 2013!14& 2014!15& 2015!16& 2016!17& 2017!18& 2018!19& 2019!20& 2020!21& 2021!22& 2022!23& 2023!24& 2024!25& 2025!26& 2026!27& 2027!28& 2028!29& 2029!30& 2030!31& 2031!32& 2032!33& 2033!34& 2034!35& 2035!36& 2036!37& 2037!38& 2038!39& 2039!40& 2040!41& 6.3 Public Finance Projections Excluding Debt Interest UK&(OBR)& Scotland&(OBR)& Scotland&(H/H)& Scotland&(M/M)& Scotland&(L/L)& The analysis earlier in this report showed that a Scottish per capita share of debt interest payments should not be part of the calculation of Scottish public finances, since historic oil revenues mean that Scotland has not contributed to the build up of UK debt. When debt interest payments are excluded from the calculation, the industrybased oil taxation projections would mean strong Scottish public finances, with significant surpluses over the next two to three decades (Figure 6-3). Under the medium scenario, the public sector surplus would be 3.3% of GDP in , 5.5 billion, with healthy surpluses continuing throughout the 2020s. Scotland Means Business: Oil & Gas Part Two The Impact on Public Finances 24

28 Under the high scenario, Scotland would have large public sector surpluses of more than 7% of GDP at the end of this decade, more than 12 billion per annum, with surpluses of between 9 billion and 11 billion per year throughout the 2020s and an average surplus of 5 billion per annum in the 2030s. Figure 6-3: Public Finance Projections with Industry-based Oil Revenues (Excluding Debt) Public'Secfor'Surplus/Deficit'as'%'GDP' 10.0%& 8.0%& 6.0%& 4.0%& 2.0%& 0.0%&!2.0%&!4.0%&!6.0%&!8.0%&!10.0%& 6.4 Summary of Projections 2013!14& 2014!15& 2015!16& 2016!17& 2017!18& 2018!19& 2019!20& 2020!21& 2021!22& 2022!23& 2023!24& 2024!25& 2025!26& 2026!27& 2027!28& 2028!29& 2029!30& 2030!31& 2031!32& 2032!33& 2033!34& 2034!35& 2035!36& 2036!37& 2037!38& 2038!39& 2039!40& 2040!41& The projections for Scottish public finances illustrated in the two figures above, are summarised in Table 6-1. They show, for example, that while the OBR is forecasting a Scottish public sector deficit of 4.0% of GDP in , the high oil revenue scenario would generate a Scottish public sector surplus of 2.2% of GDP (if debt interest was included in Scottish expenditure) and 5.1% of GDP (excluding debt interest payments). Table 6-1 Scotland s Net Fiscal Balance Summary of Scenarios (% GDP) UK&(OBR)& Scotland&(OBR)& Scotland&(OBR,&No&Debt)& Scotland&(H/H,&No&Debt)& Scotland&(M/M,&No&Debt)& Scotland&(L/L,&No&Debt)& UK (OBR) -2.2% -0.4% -1.9% Scotland (OBR-based) -4.7% -4.0% -5.4% Scotland (OBR-based, No debt interest) -1.5% -1.1% -2.7% Scotland (High-oil) -0.5% +2.2% -2.6% Scotland (High-oil, No debt interest) +2.7% +5.1% 0.1% Scotland (Medium-oil) -3.5% -1.8% -4.9% Scotland (Medium-oil, No debt interest) -0.3% +1.0% -2.3% Scotland (Low-oil) -5.9% -4.4% -6.1% Scotland (Low-oil, No debt interest) -2.7% -1.5% -3.5% Scotland Means Business: Oil & Gas Part Two The Impact on Public Finances 25

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